How should overheads be treated in litigation?
The treatment of overheads in loss of profits and account of profits claims
Introduction
In commercial litigation, a recurring point of contention is whether, and to what extent, a business’ overhead costs should be brought into account when quantifying profit or loss. The question arises in claims for breach of contract and lost income, and equally in claims for disgorgement of profits made through wrongful conduct such as patent or trade mark infringement.
In our experience as forensic accounting and valuation experts, the answer depends in part on the remedy being claimed. Two of the most commonly encountered are loss of profits, a compensatory measure of damages, and account of profits, an equitable remedy designed to strip a wrongdoer of gains made through wrongful conduct. The principles applicable to each are different and can lead to different outcomes in relation to overheads. The result, however, remains fact dependent. Matters such as whether a cost was avoided, whether it would have been incurred in any event, whether surplus capacity existed, and whether an allocation method is supported by evidence may all be relevant. The treatment of overheads can have a material impact on quantum and is often a significant area of disagreement between the parties and their experts.
This article considers the treatment of overheads under each remedy by reference to two leading Australian authorities: North Sydney Leagues' Club v Synergy Protection Agency and Dart Industries v Decor Corporation. It also considers some practical issues that arise where overheads must be allocated.
Direct and indirect costs
Business costs are commonly classified as either direct or indirect.
Direct costs
Direct costs are costs that can be attributed to a specific product, service, contract or business unit in a practical way. Wages of production line workers assembling a particular product are a common example.
Indirect costs
Indirect costs, more often referred to as overheads, are costs that support the business or a part of the business but cannot be traced directly to a particular unit of output. Examples include plant rent, head office salaries, shared IT systems, insurance and depreciation of common assets.
The distinction is not always straightforward. In litigation, how costs are characterised, allocated or excluded can make a material difference to the size of a claim.
Different remedies, different treatment of overheads
Businesses often allocate overheads across products, contracts or business units for internal reporting purposes. While useful for management and pricing decisions, those allocations do not determine how overheads should be treated in litigation.
The treatment of overheads depends on the remedy being sought. A loss of profits claim focuses on the profit the plaintiff would have earned but for the wrongful conduct. An account of profits focuses on the profit actually made by the defendant from that conduct. Because the questions are different, the treatment of overheads may differ as well.
PART A: Loss of profits (compensatory damages)
The principle
Loss of profits is a compensatory measure. Its purpose is to put the plaintiff, so far as money can do so, in the position they would have been in had the wrongful conduct not occurred. The measure is therefore the revenue that would have been earned, less the costs that would have been incurred in earning it.
Applied to overheads, the test is whether the overhead would have been saved as a result of the loss of business. Costs that would have been incurred regardless, such as head office rent, salaried staff and insurance, are not deducted, because the plaintiff continued to bear them. Deducting them would understate the loss and leave the plaintiff worse off than if the contract had been performed.
North Sydney should not be read as saying that overheads can never matter in compensatory claims. The decision does not suggest that overheads are irrelevant in compensatory claims. Rather, where the claim is for lost profits, costs are deducted from lost revenue only to the extent they were actually avoided or mitigated. Different compensatory claims, including some delay and unabsorbed-overhead claims, may raise a different question.
CASE STUDY
North Sydney Leagues’ Club v Synergy Protection Agency Pty Limited [2012]NSWCA 168
Synergy provided security services to two clubs operated by North Sydney Leagues’ Club. North Sydney terminated the contracts wrongfully, and Synergy was awarded damages for the lost profit on the contracts. The parties agreed the measure: hypothetical revenue under the contracts, less the costs Synergy would have incurred to deliver them. They disagreed on which costs.
North Sydney argued, relying on Dart Industries (discussed in Part B below), that a pro rata share of Synergy’s overheads should be deducted from the damages figure. The trial judge declined to do so, finding that overheads such as rent and the salaries of office staff continued to be paid at the same level despite the lost revenue, and so were not “saved” by the termination. The New South Wales Court of Appeal upheld that approach. As the trial judge put it, “there is no absolute principle … that account must be taken of overhead expenses”; the governing principle is “that the plaintiff is entitled to such damages as place it in the same position as it would have been had the contract been performed”.
WORKED EXAMPLE
A cleaning contractor loses a wrongfully-terminated annual contract worth $1,000,000 in revenue. Variable costs that would have been incurred to deliver the contract, including direct labour, consumables and subcontractor charges, total $600,000. Those costs are saved by the termination.
The contractor also bears $150,000 of head office overhead allocated to that contract in its internal management accounts: a share of finance, IT and the principal’s salary. None of that overhead is reduced as a result of the termination; the contractor continues to staff and run its head office at the same level.
For loss of profits purposes, the unsaved overheads are not deducted. The loss is $1,000,000 less $600,000, or $400,000, not $250,000.
Application in practice
The analysis requires consideration of the circumstances in which the overhead was incurred and whether it would have been reduced or avoided as a result of the lost activity. Each overhead must be examined to test whether, on the facts, it would have been reduced or avoided as a result of the lost activity. Variable overheads tied to volume, such as utilities, supervisory time and plant maintenance, may be partly saved. Genuinely fixed overheads typically are not. Some overheads may be wholly avoided, some not at all, and others only in part.
PART B: Account of profits (equitable disgorgement)
The principle
An account of profits is an equitable remedy. Its purpose is not to compensate the plaintiff for loss, but to strip the defendant of the profits made through wrongful conduct. The focus is on the profit actually derived by the defendant from the impugned activity, rather than the loss suffered by the plaintiff.
In an account of profits, overheads may be deductible if they form part of the cost of generating the infringing profit. The fact that overheads are allocated to a product for management accounting purposes does not determine the issue. As Dart Industries demonstrates, the defendant must establish both a connection between the overhead and the infringing activity, and a fair and reasonable basis for allocation. Whether a deduction is available will depend on the circumstances of the particular case.
CASE STUDY
Dart Industries Inc v Decor Corporation Pty Ltd [1993] HCA 54
Dart Industries elected for an account of profits in respect of Decor’s infringement of its patent over a kitchen container. Decor used absorption costing internally, allocating fixed overheads across all of its products, and contended that an apportioned share of those overheads should be deducted from the profits to be accounted for.
The High Court accepted that, in principle, overheads can be deducted in taking an account of profits. Its reasoning rested on the opportunity cost of the defendant’s productive capacity: had Decor not produced the infringing containers, it would have produced something else, and that alternative production would have absorbed part of the overheads. Refusing the deduction would credit the plaintiff with profit that did not, on any sensible view, arise from the infringement.
The Court also made two further points. First, the defendant bears the onus of demonstrating that the overheads it seeks to deduct were in fact incurred in producing the infringing item, and that the allocation is fair and reasonable. Second, the Court was clear that the exercise is one of approximation, not precision: “it is not possible to allocate general overhead specifically or with absolute precision … what is required is not mathematical exactness but only a reasonable approximation”, and “the appropriate method of allocation will depend on the nature of the business and the circumstances of the case”.
WORKED EXAMPLE
Assume the infringer can prove that, but for production of the infringing widgets, the relevant capacity would have been used to produce alternative products, and that the proposed overhead allocation is fair and reasonable.
An infringer sells $2,000,000 of widgets that infringe the plaintiff’s patent. The directly attributable costs of production, including materials, direct labour and packaging, total $1,200,000. The infringer’s factory and shared administrative overheads, allocated to the infringing widgets on a reasonable basis (say, machine hours used in production), come to $300,000.
On those facts, the account of profits is $2,000,000 less $1,200,000 less $300,000, or $500,000.
Unlike the loss of profits example above, the overhead allocation is brought into account because, on the assumed facts, it forms part of the cost of deriving the infringing profit.
Application in practice
The expert’s central task is to demonstrate, with documentary support, that the claimed overhead deduction is causally connected to the infringing activity and that the allocation method is defensible. The allocation methodology should be supported by the available evidence and reflect the way the relevant costs were incurred.
Allocating overheads
Where overheads do need to be brought into account, the exercise is not simply one of arithmetic. The key question is whether the method of allocation reflects how the business actually incurs those costs. In practice, that turns on identifying an appropriate cost driver.
Responsibility centres
Useful in service or corporate environments
Costs allocated at a functional level where that reflects how they are incurred
3. Where allocation is less straightforward
Benefits received or financial capacity approaches can be used
However, the causal link is weaker and more open to challenge
4. What courts consider
A method grounded in how the business operates
A clear rationale for the allocation adopted
An evidentiary basis for the allocation
A reasonable allocation methodology, recognising that precision is rarely possible
1. Identifying the cost driver
Ask what actually drives the cost. The closer the link between the overhead and the activity, the more defensible the allocation.
2. Common allocation approaches
Volume-based drivers
Suitable where costs scale with activity
Examples: units produced, labour hours, machine hours
Activity-based drivers (ABC)
More precise where overheads are driven by specific processes
Examples: machine setups, maintenance hours, purchase orders
CONCLUDING OBSERVATIONS
The treatment of overheads in commercial litigation is not mechanical. There is no universal rule requiring their inclusion or exclusion. The outcome depends on the remedy sought and the facts of the case.
Three points matter in practice:
1. The remedy remains the starting point
For loss of profits, the question is whether the cost was avoided or mitigated by the breach. Costs that continued to be incurred despite the lost revenue will generally not be deducted.
For an account of profits, the question is whether the cost is properly attributable to the impugned activity and fairly allocable as part of the defendant’s actual gain. That requires evidence both that the overhead supported the relevant activity and that the proposed allocation method is reasonable in the circumstances.
The same overhead may therefore be treated differently depending on the remedy sought and the circumstances of the case.
2. Allocation methodology
Where overheads are brought into account, courts expect a method grounded in how the business actually operates. Cost driver-based approaches are generally more persuasive than allocations based on convenience or broad financial metrics.
The appropriate allocation method will depend on the nature of the business and the circumstances of the case. Common approaches include machine hours, labour hours, production volume or activity-based costing methodologies where those reflect the underlying drivers of cost incurrence.
3. Evidentiary considerations
How overheads are characterised, evidenced and allocated can materially affect quantum. For that reason, they should be addressed early in the framing of a claim or defence, not treated as a secondary accounting issue.
From an expert evidence perspective, contemporaneous management accounts, costing methodologies, capacity utilisation evidence and operational data will often be central to determining whether a claimed overhead deduction is supportable.
Hewlett + Murray is an Australian forensic accounting and valuation firm specialising in expert witness and dispute advisory services. We provide independent expert evidence and financial advisory support in commercial litigation, including economic loss quantification, account of profits, intellectual property disputes, shareholder disputes, post-acquisition disputes and business valuation matters.
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